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Guide to Employee Stock Option Plans (ESOPs)

· 4 min read
Guide to Employee Stock Option Plans (ESOPs)
Welcome to our guide on Employee Stock Option Plans - ESOPs, which will give you a detailed understanding of this interesting form of ownership and employee compensation plan.

Although we may not cover all the details you need for your specific company and situation, we're here to provide you with a solid foundation to feel ready to implement an employee stock option plan.

1. What is an ESOP - Employee Stock Option Plan?

An ESOP is a structured incentive stock option, also known as a form of retirement plan, that companies offer to their employees so they can become owners in the company they work for.

By being part of your company’s ESOP, you can purchase company shares at a predetermined price so that, if needed, executive employees can even receive voting rights or a place on the board of the company. In some cases, this happens instantly, and in other cases, it happens after a short-term period or some years.

ESOPs can be a win-win for both companies and employees.

They can improve employee morale, productivity, and retention while providing companies with tax advantages and a way to transition ownership. The primary motivation behind ESOPs is to ensure that you and your company have the same goals and try to achieve the same results.

However, we must make a few things clear before.

Are there more types of ESOPs?

ESOPs may take different forms, each with its characteristics.

Depending on your company's decision, you may receive options to purchase company shares at a specific price, be granted actual shares upfront, or receive cash equivalents tied to company stock performance (phantom stock). The choice of type often depends on the company's objectives and what works best for the employees.

Is anything common to all these ESOP types?

ESOPs are not universally applicable to any employee and often are restricted to some categories of employees based on factors such as job roles, tenure, performance, and individual qualifications. Vesting is a core principle present in all ESOPs.

Vesting represents a timeframe over which you may gain ownership rights to the granted options or shares. This timeline is meant to encourage your loyalty and engagement, as it rewards your ongoing commitment to the company's growth.

How do I get to be part of the ESOP?

The participation depends on a combination of factors, including your term with the company, your individual performance metrics, and sometimes, if you leave the company, your exit status (good or bad leaver).

Companies usually define these criteria to ensure that employees who contribute positively to the company's objectives benefit from the ESOP. Learn more about how to foster a culture of ownership in your company, how many types of plans are available, and which option is best for you.

2. ESOP vs. salary and a cash bonus?

Well, as always, there are advantages and disadvantages to every situation. Although you may prefer one or the other, typically, your company will decide on a specific mix of ESOP and cash bonuses for employees, and you may not be able to change this.

What you could do is change your activity in the company to reach one or another of the goals tied to these types of rewards. The best option for you depends on your circumstances and risk tolerance. Salary and cash bonuses might be better for stability and predictability.

ESOP advantages.

Being part of an ESOP may give you several compelling advantages. The value of your options or shares can grow over time, providing you with a potential financial gain.

Additionally, ESOPs often come with tax benefits, allowing you to pay less taxes or to pay them later than if you get a cash reward (typically both). It may also be easier for the company to give you options or shares than cash.

Furthermore, you may realize significant earnings during equity events such as acquisitions or initial public offerings (IPOs).

  • Employee retention and motivation — Employees become part owners of the company, increasing morale, productivity, and overall commitment to the company's success. They have a stake in the game.
  • Tax-deductible benefits — Depending on each country, there are significant advantages for both companies and employees. Companies can deduct contributions to the ESOP from their income tax, and employees can defer paying taxes on ESOP shares until they are sold.
  • Retirement benefits — ESOP shares can help an employee's allocation for retirement savings. Employees can sell their shares and use the proceeds to fund their retirement when they leave the company.

ESOP disadvantages.

Where there’s no pain, there may be no gain.

Accessing the ESOP’s advantages has some features you need to consider. The main one is the potential need for upfront capital to exercise options or purchase shares.

Additionally, there may be a time delay before you can fully benefit from your ownership stake. Furthermore, you will participate in all your company's ups and downs. The value of shares of stock can decline if the company's performance does not meet your expectations, meaning that, in worse cases, you may lose money instead of making a profit.

For example, liquidity is one disadvantage, where employees typically can't sell their ESOP shares until they leave the company or retire. This can limit their ability to access the money.

3. The 4 stages of implementing your ESOP.

Unlike traditional compensation methods like salary and bonuses, ESOPs tie your financial success to the company's performance. But how exactly do you become an owner through an ESOP?

There are four key stages in implementing an ESOP:

  1. Negotiation.
  2. Granting.
  3. Vesting.
  4. Exercising.

Each stage plays a role in transforming your employee status into partial ownership.

Let's delve deeper into these stages to understand how you transition from potential ownership to a vested shareholder in your company.

Step 1 — Negotiation.

Joining an ESOP often involves negotiations between you and the employer. During this negotiation phase, you may or may not discuss if you are to be included in the company ESOP, the terms of your participation, the targets you may be required to achieve, your vesting schedule, and your potential ownership stake.

Some ESOPs might have performance-based targets linked to your ownership stake. Negotiating for achievable targets can ensure you get the ownership you deserve. You might also be able to discuss the initial size of your ownership, though this may have limitations depending on the company's structure.

Not all of them are typically negotiable, but if you start working with the respective company, your ESOP participation and the related conditions will be part of your compensation package.

While some companies automatically include all employees in the ESOP, others might have eligibility criteria. Negotiation might involve advocating for your inclusion based on your value and contribution.

Ultimately, the decision depends on your circumstances:

  • Risk tolerance: If you're comfortable with some risk, an ESOP with high growth potential could be a good fit.
  • Career stage: Early-career professionals might prioritize immediate financial security, while established professionals might be more open to an ESOP's long-term potential.
  • Financial goals: If you're saving for a down payment on a house, a guaranteed salary might be more important than an ESOP with uncertain future value.

Step 2 — Granting.

The granting phase is a necessary step in the ESOP process. The granting phase is when you are awarded the right to own shares in the company.

Granting usually occurs according to a predetermined schedule or criteria, as defined by the ESOP plan. The granted options or shares represent the potential for your future ownership, subject to vesting conditions.

Don’t forget that your ESOP has to be reflected within your company’s cap table. The cap table tracks ownership of a company by detailing who holds what shares, stock options, and other securities. ESOP inclusion helps manage and visualize employee ownership.

During the granting phase, you will receive information about how many shares/options you could receive overall and in which conditions, including:

  • Number of Shares/Options: This specifies the total number of shares or options you are potentially eligible to receive.
  • Vesting schedule: This outlines the timeframe and conditions under which you gain full ownership of your granted options or shares. Vesting typically happens gradually over a set number of years, and some plans may have service requirements (staying with the company for a minimum period) to be eligible for full vesting.

Step 3 — Vesting.

Vesting is a critical concept within ESOPs, signifying you will gradually accumulate ownership rights over time or upon achieving specific performance milestones. Vesting schedules can be structured in two main ways:

  • Time-based vesting: Ownership rights accrue gradually over a predetermined period, often several years. This is the most common approach, encouraging long-term commitment from employees.
  • Milestone-based vesting: Ownership rights are granted upon reaching specific company goals or performance targets. This approach directly links your ownership stake to the company's success, further aligning your interests.

Vesting serves a dual purpose. It protects the company's ownership structure by ensuring continued employee commitment, and it motivates you to remain invested in the company's growth and success over time.

The closer you get to full vesting, the greater your ownership stake and potential financial reward become.

Step 4 — Exercising.

The exercise phase is converting your vested options into actual shares by purchasing them at a predetermined price, typically the strike price in the option agreement.

Alternatively, if the ESOP involves direct share ownership, you may buy shares at the predetermined price. This decision allows you to become partial company owners and benefit from any future increase in share value.

However, you may decide not to exercise your vested options or buy the vested shares. They may remain at your disposal for a certain period, after which they are canceled, and you cannot exercise them anymore, so check the exercising conditions carefully.

Keeping track of what’s going on during all these phases, following the vested options, and exercising them may confuse you and your employer.

4. Frequently asked questions — granting.

Who decides how many shares or options I’m granted?

The company's management team or board of directors typically decides to grant options or shares to employees. These decisions align with the company's goals and the desired employee participation in ownership.

You may negotiate how many shares/options you will be granted when you start working for the company or upon some promotion, but other than that, once decided, your package will likely remain unchanged.

Will there be no changes once I’m granted some shares/options?

While changes to granted shares or options are relatively uncommon, sometimes they may happen under specific circumstances, such as changes in company structure or regulatory requirements. Also, you may renegotiate your ESOP package if you get a new position or in case of exceptional performance.

Significant corporate events, such as fundraising rounds or listings on stock exchanges, can impact the value and accessibility of options or shares, lead to a revaluation of options or shares, and may trigger adjustments to the terms and conditions of the ESOP.

Is there a specific negotiation period?

The terms and conditions of granting options or shares are usually negotiated during onboarding or at specific intervals, depending on company policies.

So check what the company is saying about the ESOP (there are some specific documents at the company level describing exactly how the ESOP works).

How do I see the status of my shares/options?

Typically, thoughtful companies provide their employees with a tool or platform allowing them to track their granted options or shares and ensure visibility into their ownership stake.

Companies and employees can work on building a single source of truth for equity compensation. SeedBlink offers you the place and tools to go from a simple promise in front of employees to actual ownership of the company and profit-sharing.

5. Frequently asked questions — vesting.

Vesting is a concept that is always found at the core of any ESOP, as it rewards employees' loyalty and sustained commitment (meaning the company rewards stable and productive employees).

By tying ownership rights to your time with the company or performance milestones, vesting should encourage you to remain engaged and contribute to the company's growth.

Are there more vesting types?

There are two primary types of vesting: time-based and milestone-based.

Time-based vesting will rely on your length of service, gradually unlocking ownership rights over a predetermined period. Milestone-based vesting, on the other hand, is tied to achieving specific goals or milestones (yours or the company’s), resulting in ownership rights upon successful accomplishment.

What is a Vesting schedule?

A vesting schedule outlines the timeline for gaining ownership rights to your options or shares. This schedule is crucial for you, clarifying when you can exercise your ownership rights. In some cases (acquisition, investment round, IPO), the company could accelerate your vesting schedule, meaning all your shares/options still not vested may vest immediately.

What are Vesting conditions?

Detailed vesting conditions, including the specific milestones or performance metrics, are usually outlined in official company documents or designated platforms. These conditions provide a transparent framework to see exactly where you stand in your progress toward ownership.

Is there a way to see my vesting situation?

The same platform that shows you the granting situation (see the section above) typically allows you to see which shares/options are vested and exercise them (see below).

6. Frequently asked questions — option exercising.

Do I need to pay to get shares/options?

Exercising options or purchasing shares under an ESOP may require a certain price. This applies to purchasing the options at the predetermined strike price or directly buying shares.

The price may be lower than the share market price but may represent a significant amount for you.

Do I need to exercise all my vested shares/options?

Employees are often granted the flexibility to exercise only a portion of their vested options, enabling them to manage their financial commitments strategically. So, you could exercise only part of your vested shares/options or none at all.

Should I decide immediately upon vesting how many shares/options to exercise?

You are not obliged to exercise your vested options immediately upon becoming eligible. You can choose when to exercise within a specified timeframe, allowing you to consider market conditions and your financial situation. However, be careful, as this timeframe may be limited, so after a while, your shares/options may be lost if you do not exercise them.

Do I need to pay taxes upon exercising?

When you exercise your options or purchase shares, a tax obligation on capital gains is always attached.

However, how many taxes you should pay and when depends on factors such as the timing of exercise, the difference between the strike price and the market value, and local tax regulations. In each country, there are some tax advantages for ESOP members, so be sure to check the specific conditions in your case with your company.

What happens after I get the shares?

Upon exercising options or purchasing shares, you become a partial company owner with the potential to benefit from any future appreciation in share value.

If the company's value grows, your share of the company increases, too. If the company does not perform well, your shares may lose value.

7. Other frequently asked questions.

What happens if I leave the company during the vesting period?

Employees who leave the company may have different outcomes for their vested options or shares based on their exit classification.

Those deemed "good leavers," typically leaving for reasons such as retirement or amicable departures, may retain ownership rights. "Bad leavers," who exit under less favorable circumstances, may face restrictions on ownership rights or have to relinquish them.

However, shares you already own when you are leaving remain yours under any circumstances.

Could I sell my shares/options?

Sometimes, you may be able to sell your vested shares or options.

However, this is subject to the company's policies, regulatory considerations, and contractual restrictions. Selling can give employees liquidity and the opportunity to realize value from their ownership stake.

How do I know the value of my shares/options?

Determining the value of options or shares in an ESOP can be complex and is often tied to various factors. These factors include the company's financial performance, industry trends, market conditions, and potential future equity events.

Valuation methods to establish the fair market value of shares may involve the engagement of professional valuation experts to ensure accuracy and fairness, so most likely, you will not perform this valuation on your own.

Companies who implement ESOPs usually perform such valuations from time to time, as in some countries, this is required by law, while in other countries, even if not mandatory, the company does valuations from time to time for the benefit of the ESOP employees and shareholders.

Profit/loss calculation example.

To visualize your ESOP from a better perspective, let’s go together through a quick exercise and calculate your profit or loss if you buy ESOP shares in your company under different scenarios.

Let’s say you buy ESOP shares worth 1,000 EUR at a strike price of 0.85 EUR when the company value is 1 mil EUR and the share price is 1 EUR.

We have the following situations:

  1. The company value stays the same.
  2. The company value diminishes to 900.000 EUR.
  3. The company value diminishes to 500.000 EUR.
  4. The company value increases to 3 mil EUR.

Initial Information:

  • Current Company Value: 1,000,000 EUR
  • Strike Price: 0.85 EUR (The price at which you purchase the shares)
  • Share Price: 1 EUR (The market price per share at the moment of calculation)

In summary, your profit or loss from buying ESOP shares depends on the change in company value and share price. In Scenarios 1, 2, and 4, you experience profits due to company value or share price increases. However, in Scenario 3, you incur losses due to decreases in company value and, thus, the share price.

Even if the company value decreases, you win if the share price remains over the strike price. If the share price decreases below this limit, you lose.

8. What could SeedBlink do for me?

Our platform is designed to effectively manage employee stock ownership plans, simplifying various aspects of the process for you and your company.

  • Tracking Options/Shares: SeedBlink provides a centralized view of your granted options or shares. Using our platform will keep you organized around your ownership status.
  • Vesting Schedule Monitoring: You can rely on us to monitor your vesting schedule. This feature ensures that you are well aware of your progress toward exercising your ownership rights based on predetermined milestones.
  • Facilitating Exercise: Streamline the exercise process, simplifying converting options into shares or purchasing shares at the strike price. This streamlined process minimizes administrative hurdles and allows you to focus on ownership decisions.
  • Complete Overview: Our platform offers a detailed view of all ESOPs in which you participate. This allows you to understand your cumulative ownership across various companies clearly.
  • Secondary Market Access: SeedBlink will provide access to a secondary market for buying or selling shares/options. This market offers liquidity and flexibility and will allow you to manage your ownership portfolio based on changing financial needs or market conditions.

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